VOLUME XXX JANUARY 2015

INVESTMENT ISSUES STRATEGIES INSIGHTS FROM DONVILLE KENT

Net Worth
2014 was another solid year for Canadian equity investors and a strong year
for the Capital Ideas Fund. In 2014, the S&P/TSX Total Return Index rose
10.6%1 while the Capital Ideas Fund was up 22.7%2. In 2014, the key portfolio
decisions we made were to be overweight knowledge-based industries
(pharmaceuticals, software, IT services) and relatively underweight natural
resource stocks. As most investors are aware, oil, along with most other
commodities, nosedived in the second half of 2014.
As we enter 2015, we have a few concerns. Both the US Dollar and oil have
made massive moves in terms of price, and I expect that the effects of these
moves have yet to be fully felt. In the coming months, the appreciation (US$)
and depreciation (oil) of these two items will have a significant impact on
earnings forecasts and employment in Canada and abroad. The exact winners
and losers will become more obvious as the year unfolds. Until then, we are
playing things a bit cautiously.
As far as the positioning of the Capital Ideas Fund goes, we look relatively
similar at the start of 2015 to the way we were in 2014, with the exception that
we are relatively light on financial services companies. Natural resource and
financial services companies make up roughly 70% of the TSXs
capitalisation, but at the time of this writing they make up less than 15% of the
Capital Ideas Fund. So what then do we own? We currently have 23% of the
fund in pharmaceutical companies and 43% in software and IT services
companies. That said, we are looking at the oil and gas sector closely and our
weightings in this sector will probably rise as the year moves forward.

By the book
Many people who read my newsletters recommend books that they think I
might enjoy reading or that I might learn something from. And to those who do
so, I only have two words to say: THANK YOU. I dont read every book you

recommend to me, but a few books that have caught my attention have been
terrific. So once again, thank you for bringing them to my attention.
The first book that was recommended to me is titled The Little Book That
Builds Wealth by Pat Dorsey. This is an extremely well-written book that
covers all of the major factors that drive competitive advantage in a company.
Dorsey has a tight, crisp writing style and early in the book he identifies what
an economic moat is and why it is so important. Dorsey is drawn to companies
that can earn high returns on capital. As he points out, the strength of the
economic moat will determine both how high the growth rate is and how long
it will persist. In the first half of his book, Dorsey shows that companies that
can earn above average returns for long periods of time are the ones that are
protected in some way by brands, patents, economies of scale, etc. This in turn
results in a strong, long-term growth profile, which allows for the magic of
compounding. This, in my view, is the heart of long-term investing. Dorseys
book describes this phenomenon better and more succinctly than just about any
other book on this topic that I have read.
The second half of Dorseys book is equally valuable and explains a simple
process for looking at competitive advantage from a stock-picking perspective.
His three step process is virtually identical to ours, and I believe it is extremely
valuable to investors in picking the kinds of stocks that can compound over
long periods of time. Those three steps, which are posed as questions, are
summarised as follows;
Step 1 Has the firm historically generated solid returns on capital?
Step 2 Does the company have one or more of the competitive
advantages described in Dorseys book?
Step 3 How strong is the companys competitive advantage? Is it
likely to last a long time or a relatively short time?
If the goal of an active investor is first to identify a great company (and
subsequently decide what an attractive price to pay for that company is), then
one should view Dorseys three steps as the key starting place in deciding
what is a great company?
So how exactly does Dorsey go about this process? Just as we do at Donville
Kent, Dorsey begins Step 1 by building a simple table that examines a
companys historical track record. In Dorseys simple table, he looks at the ten
year track record of a company in the context of only four ratios: net margin
(%), return on assets (%), financial leverage (x), and return on equity (%).
This snapshot, he believes (and we agree), gives you a very quick but
nonetheless, thorough first look at a companys competitive position over a

ROE REPORTER | DKAM

reasonably long period of time. I cant reiterate enough how important this step
is in identifying potentially great, high return on equity companies.
So what do each of the metrics show us? Net margin gives us an idea of the
trend in margins over time as well as the fatness of the margin. Both are
excellent measures of whether a firm has a competitive advantage and if it is
getting stronger, weaker, or is staying the same. Return on assets is his second
metric. It shows us how profitable the company is on an unleveraged basis as
well as showing us if the trend and returns on the companys asset base are
stable, improving, or deteriorating. Leverage shows us the ratio of assets to
equity. The leverage ratio is more comprehensive than a simple net debt to
capital ratio and it gives us an idea of how much the ROE is being lifted by
leverage as opposed to margins.
Finally, ROE is the all in number that gives us a quantitative measure of how
competitive the company is in relation to its cost of equity and in comparison
to other companies in which we might consider investing. ROE is also a superb
measure of the growth of the net worth of the business and in our view a much
better measure than either sales growth or EPS growth. At Donville Kent we
view an ROE of 20% or better to be a superb level of competitive advantage
and the threshold we target with our investments.
Dorseys approach to identifying great companies by building a table with the
historical track record of the company is really important. We have said before
that once an investor does this, the great companies leap off the page and the
mediocre companies become obvious. Steps 2 and 3 in Dorseys process are a
little more challenging, because most investors do not have the time to
undertake a thorough competitive analysis of a business. However, if you have
completed Step 1 right, you are still way ahead of the average investor, as you
have already screened out the poor and average companies from your possible
choices.
So how do we assess the competitive advantage of the company once we have
generated a short list of potential investments? My recommendation is that you
try to get a handle on a companys products and services and use a book like
Dorseys to ensure you have been as thorough as possible with your analysis.
The trends in margins and ROE will give you some sense of where problems
might arise. The rest is really the art of investing!

The super allocators

In 1962, long before Warren Buffett became a household name, he began
acquiring shares in a small New England textile company called Berkshire
Hathaway. By 1965, he controlled the company. While Berkshire stock was

ROE REPORTER | DKAM

undervalued the company was far from a superb business, and by 1967, Buffett
had already begun to allocate capital away from the textile business and into
insurance and other businesses. The textile business never proved to be a good
one, and by 1985 it was shutdown. But Buffett turned out to be a superb capital
allocator, and while his textile business slowly died, Berkshire, under Buffetts
control, flourished. Today it is one of the largest and most profitable
companies in the world.
Buffetts life as a capital allocator is well documented in William N.
Thorndike, Jrs book, The Outsiders, which features seven chapters on seven
amazing CEOs and an eighth chapter on Buffett. Like Buffett, many of these
CEOs found themselves early in their career running businesses that did not
appear to have great economic moats. Thorndike shows how a series of
capital allocation decisions slowly turned each of these businesses into
compounding machines. Besides Berkshire, we hear the stories of Teledyne,
Ralston Purina, General Cinema, TCI, and the Washington Post. Not all of
these companies are household names, but in each case study there is a
marvelous story of a CEO and management team who were focused on return
on equity and delivered amazing results for their shareholders.
I think Thorndikes case studies highlight something I noticed many years ago.
We sometimes encounter companies that dont appear to have an easily
identifiable competitive advantage yet manage to deliver returns on equity that
are well above industry averages. I believe that the superior capital allocation
skills of the CEO and management team are in many cases the key
differentiating quality of the company. All of the companies and CEOs that
Thorndike writes about have this quality, which in my view illustrates just how
powerful management can be on an otherwise ordinary business.
Thorndikes examples all come from the United States. Regrettably, no such
book exists on great Canadian capital allocators. If such a book existed, I
would love to see a chapter on Constellation Software (Mark Leonard), Paladin
Labs (Jonathan Goodman), Home Capital (Gerry Soloway), and MTY Food
Group (Stanley Ma). This is not an exhaustive list, but each of these CEOs has
been, and remains, a superb allocator of capital. This excellence is reflected in
the share prices of the companies that they ran or continue to run. Pull out a
long-term share price chart on any of these four companies and you will be
astounded at what you see.
Thorndikes book is a valuable one for investors because, as the Buffett
chapter aptly shows, the ability to intelligently allocate capital may be even
more important than the competitiveness of a companys products and
services. The TSX is full of companies with competitive products and services
that do not make an acceptable return on equity. Thus, an important conclusion
is that great companies must have both competitive products and a

ROE REPORTER | DKAM

management team than can astutely allocate capital. Such qualities are easy
enough to describe, but in reality, a company that is strong in both areas is rare.

An investment portfolio centred on management and competitive

advantage
Our fund is built around the ideas and concepts so adeptly addressed in
Dorseys and Thorndike Jr.s book. We are looking for companies that can
earn an ROE of 20% per annum on a consistent basis. We believe these
companies possess products that are highly competitive, deliver above average
margins, and are run by management teams that work on keeping those
products competitive. Those same managers have the added skill of being able
to allocate capital intelligently so as to keep ROEs high on a multi-year basis.
In choosing each years short list of great stocks to own we start by
screening through our database in pursuit of the 25 companies that have the
best ROEs in the country in the current year, while also boasting market caps
in excess of $500mm. All of the data in the following figures is based on our
adjustments. These include normalising all ROEs for a companys dividend
policy and adding back amortization of intangibles to GAAP earnings to
provide us with cash earnings.

*return on average equity, based on cash earnings and adjusted for dividends

ROE REPORTER | DKAM

Figure 1 shows us a list of fairly high-quality companies that we expect will

deliver above average ROEs in 2015. This list does not make any reference to
valuation, and so before we dig in too far, we would like to know which
companies are cheap and which are expensive before we do too much work.

Figure 2 above takes the same list of companies and ranks them by their 2015
projected P/E ratios. The dispersion of forward P/E ratios ranges from Yellow
Pages 3.0x to Intertain Groups 27.4x. In our view, none of these valuations is
stratospheric but equally, the cheaper ones provide a certain margin of safety.
In Figure 3 we combine our estimate for ROE and P/E to get a sense of which
companies offer the most growth per unit of valuation (ROE divided by P/E).

ROE REPORTER | DKAM

Five great stocks for 2015

Home Capital Group (HCG) Toronto-based Home Capital is the largest
independent Mortgage and Trust Company in Canada. The company has been
run by Gerry Soloway for close to 30 years, and the companys ROE has not
fallen below 20% in more than 15 years. The company mitigates risk by using
low leverage relative to other banks and trust companies and by focusing on
loan-to-value mortgages. Home Capital is the seventh largest position in the
Capital Ideas Fund.
Figure 4 - Home Capital Group
FYE Dec
2009A
Rev ($MM)
Cash Earnings ($MM)
Cash EPS ($)
Net margin (%)
ROAE*
Source: Donville Kent

277.6
145.4
2.11
52%
28%

2010A

2011A

2012A

2013A

2014E

2015E

308.8
181.0
2.61
59%
27%

361.3
190.8
2.75
53%
25%

422.7
228.7
3.30
54%
26%

481.2
264.4
3.80
55%
25%

562.6
309.2
4.39
55%
24%

658.2
346.2
4.91
53%
21%

Constellation Software (CSU) Toronto-based Constellation Software is run

by the best management team in Canada. Constellation operates more than 200
best of breed software companies throughout Canada, the United States, and

ROE REPORTER | DKAM

Europe that throw off a tremendous amount of cash. It has been growing at
more than 30% per annum for the past five years. The company also boasts a
strong balance sheet and significant employee ownership.
Figure 5 - Constellation Software
FYE Dec
2009A
Rev ($MM)
Cash Earnings ($MM)
Cash EPS ($)
Net margin (%)
ROAE*
Source: Donville Kent

437.9
70.8
3.35
16%
68%

2010A

2011A

2012A

2013A

2014E

2015E

634.0
97.9
4.62
15%
76%

773.3
158.8
7.49
21%
80%

891.2
177.8
8.39
20%
69%

1,210.8
212.2
10.02
18%
81%

1,710.5
261.7
12.35
15%
96%

1,980.5
345.7
16.31
17%
46%

CGI Group (GIB.A) CGI is a Montreal-based IT services company that

operates throughout the world. The company routinely generates an ROE in
excess of 20% per annum yet trades at a very reasonable 11.6x 2015 earnings.
The company has been aggressively paying down debt over the past 24
months, and we suspect the company will make a significant acquisition in
2015, which should give it a nice jump in earnings in either 2015 or 2016.
Figure 6 - Glentel
CGI Group
FYE Sep
Rev ($MM)
Cash Earnings ($MM)
Cash EPS ($)
Net margin (%)
ROAE*
Source: Donville Kent

2009A

2010A

2011A

2012A

3,825.2
451.6
1.47
12%
21%

3,732.0
506.9
1.78
14%
23%

4,223.9
574.6
2.17
14%
26%

4,772.5
486.2
1.58
10%
17%

2013A

2014A

2015E

10,084.6 10,499.7 10,805.6

988.2
1,179.5 1,281.0
3.21
3.82
4.12
10%
11%
12%
26%
26%
23%

Badger Daylighting (BAD) Calgary based Badger Daylighting is North

Americas leading provider of non-destructive hydrovac excavation services.
Badger traditionally works for contractors, engineers, and facility owners in
the oil and gas, power, municipal, transportation, industrial and commercial
construction industries. Badger has one of the most attractive ROE profiles
amongst industrial companies in Canada.
Figure 7 - Badger Daylighting
FYE Dec
2009A
Rev ($MM)
Cash Earnings ($MM)
Cash EPS ($)
Net margin (%)
ROAE*
Source: Donville Kent

135.0
19.8
0.61
15%
30%

2010A

2011A

2012A

2013A

2014E

2015E

139.6
17.7
0.55
13%
25%

194.2
27.1
0.84
14%
33%

239.2
26.9
0.77
11%
23%

324.6
46.1
1.25
14%
30%

426.1
58.3
1.57
14%
30%

460.0
60.2
1.63
13%
22%

ROE REPORTER | DKAM

Valeant Pharmaceuticals (VRX) This Montreal-based multinational

pharmaceutical company has a focus on branded, generic, and over-the-counter
pharmaceutical products. The company has proven itself to be an astute
acquirer as well as a strong grower and developer of its existing brands.
Valeant management have shown themselves to be excellent allocators of
capital, and we expect the companys ROE to exceed 25% in 2015.
Figure 8 - Valeant Pharmaceuticals
FYE Dec
2009A
Rev ($MM)
Cash Earnings ($MM)
Cash EPS ($)
Net margin (%)
ROAE*
Source: Donville Kent

820.4
281.1
1.78
34%
22%

2010A

2011A

2012A

2013A

2014E

2015E

1181.2
11.6
0.06
1%
0%

2463.5
717.4
2.35
29%
16%

3480.4
812.9
2.66
23%
21%

5769.6
1035.8
3.10
18%
23%

8210.0
2307.4
6.88
28%
44%

9128.7
3370.2
10.05
37%
35%

Final Thoughts
I am quite happy with the way 2014 worked out, but dont assume that I am
getting complacent. I know a majority of the people who have invested in the
fund and I take your trust very seriously. My pledge for 2015 and beyond is to
grow your savings while doing my best to mitigate the risks that I can hedge.
Thank you for your trust and support.
I also wanted to say a quick thank you to Mike Scott and Sumit Mittal for
recommending the two books I discussed earlier in the report.
Finally, I want to say thank you to my team for another great year. They are, of
course, Jordan, Ali, Jesse, Chris, and Dominika. I love coming to work each
day, in part because I am surrounded by smart, intelligent, honest and hardworking people. Working with each of you is a real pleasure.
Call me or write me if you want to chat J.P. Donville
Jason@donvillekent.com - 416-364-8886

1
2

markets.ft.com
Time weighted rates of return for Class A Series 1, net of all fees and expenses

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DISCLAIMER
Readers are advised that the material herein should be used solely for informational purposes. Donville Kent
Asset Management Inc. (DKAM) does not purport to tell or suggest which investment securities members or
readers should buy or sell for themselves. Readers should always conduct their own research and due diligence
and obtain professional advice before making any investment decision. DKAM will not be liable for any loss or
damage caused by a reader's reliance on information obtained in any of our newsletters, presentations, special
reports, email correspondence, or on our website. Our readers are solely responsible for their own investment
decisions.
The information contained herein does not constitute a representation by the publisher or a solicitation for the
purchase or sale of securities. Our opinions and analyses are based on sources believed to be reliable and are
written in good faith, but no representation or warranty, expressed or implied, is made as to their accuracy or
completeness. All information contained in our newsletters, presentations or on our website should be
independently verified with the companies mentioned. The editor and publisher are not responsible for errors or
omissions. Past performance does not guarantee future results. Unit value and investment returns will fluctuate
and there is no assurance that a fund can maintain a specific net asset value. The fund is available to investors
eligible to invest under a prospectus exemption, such as accredited investors. Prospective investors should rely
solely on the Fund's offering documentation, which outlines the risk factors in making a decision to invest.
The S&P/TSX Composite Total Return Index ("the index") is similar to the DKAM Capital Ideas Fund LP ("the
fund") in that both include publicly traded Canadian equities of various market capitalizations across several
industries, and reflect both movements in the stock prices as well as reinvestment of dividend income. However,
there are several differences between the fund and the index, as the fund can invest both long and short, can
utilize leverage, can take concentrated positions in single equities, and may invest in companies that have
smaller market capitalizations then those that are included in the index. In addition, the index does not include
any fees or expenses whereas the fund data presented is net of all fees and expenses. The source of the index
data is S&P/Capital IQ.
DKAM receives no compensation of any kind from any companies that are mentioned in our newsletters or on
our website. Any opinions expressed are subject to change without notice. The DKAM Capital Ideas Fund,
employees, writers, and other related parties may hold positions in the securities that are discussed in our
newsletters, presentations or on our website.

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